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Investment Overview for Chesapeake (NYSE:CHK)

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Chesapeake Energy is the second largest producer of natural gas and the tenth-largest producer of liquids in the United States. The company is also one of the most active drillers of new wells in the U.S. The company's operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the U.S. It owns positions in the Barnett, Fayetteville, Haynesville, Marcellus and Bossier natural gas shale plays and in the Eagle Ford, Granite Wash, Niobrara and various other conventional and unconventional liquid-rich plays across the U.S. The firm has interests in over 46,800 producing natural gas and oil wells that produce over 665 thousand barrels of oil equivalent per day.

The natural gas assets that the company built over the years are very lucrative. However, of late, the company's operations have taken a beating due to relatively low natural gas prices. As a result, it has shifted its focus towards oil and natural gas liquids, spending heavily on building liquid-rich or oil assets. Meanwhile, the company has been grappling with liquidity issues. In 2012 and 2013, the firm divested around $11 billion and $4 billion in assets respectively.

Over the last few quarters, the company has been divesting its midstream, gathering and some of its compression assets. The company also announced that it was perusing strategic alternatives for its oilfied services subsidiary, including an outright sale or a spin off.

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Higher margins for natural gas and oil divisions

Prior to the recent economic downturn, which impacted EBITDA margins across all divisions, natural gas and oil EBITDA margins averaged around 85%. Margins declined to 76% in 2011 as natural gas priced dropped substantially. However, the division is so valuable because even during times of near-record low prices it was able to maintain margins in excess of 75%. This is because the low prices were offset by higher volumes.

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Increasing focus on liquids production

Over the last several quarters, Chesapeake Energy has been ramping up its oil and liquids production, diversifying its revenue stream away from the volatile natural gas market. Now, liquids account for more than 65% of the company’s production revenues. Prices for liquids are more stable and track global oil prices while the company's natural gas price realizations are more volatile since they are largely dependant on the U.S. markets. Much of the company’s transformation from being primarily a natural gas company to an oil producer has been spearheaded by its assets in the Eagle Ford Shale in the south of Texas.

Higher costs associated with upstream activities

Chesapeake largely produces oil and gas from unconventional resources such as shales. Much of the company's production growth in recent times has come from drilling its most promising and lucrative acreage. However, after these areas are drilled, the company will likely have to move to less productive regions. This could mean that the company will need to drill more aggressively to keep up its output. This could translate to higher production expenses in the long run.

Coal as an alternative to gas

Coal and natural gas are the closest substitutes as a fuel for electricity generation. Surges in coal demand are generally associated with a drop in gas demand and vice-versa. While coal demand has been significantly impacted by lower gas prices over the last few years, there was a slight reversal in 2013 and early 2014 as natural gas prices rose sharply, prompting utilities to burn more coal as opposed to gas, leading to sluggish gas sales volumes for Chesapeake.

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We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.

We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

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